Knightian Financial Markets

22 August 2007 at 9:24 am Peter G. Klein 2 comments

| Peter Klein |

Frank Knight knew in 1921 what the world’s most sophisticated mathematical models could not capture today. That is, there is a fine line between risk with mathematical probabilities and uncertainty that cannot be measured. Although investors have no difficulty in pricing all sorts of risks, the “immeasurable” uncertainty and information asymmetries make them shy away from all forms of risk, especially in times of global anxiety. In our view, this is exactly what has happened in the past couple of weeks in financial markets, as credit risks linked to the US subprime-mortgage market spread out (through highly leveraged derivatives and structured instruments) and triggered a volatility wave across the world.

That’s Morgan Stanley’s Serhan Cevik and Katerina Kalcheva, writing in yesterday’s Global Economic Forum. Kudos to Cevik and Kalcheva for reminding investors (or, more likely, economists) that some risks cannot be measured and priced. But keep in mind that Knight treated uncertainty as ubiquitous, not some parameter that rises and falls with market conditions. “Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless,” as he famously put it. (BTW you can get the full text of Risk, Uncertainty, and Profit online, courtesy of EconLib.)

Entry filed under: - Klein -, Management Theory, Strategic Management.

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2 Comments Add your own

1. spostrel | 27 August 2007 at 7:55 pm

I have always been baffled by how much some people like this risk/uncertainty distinction. Undoubtedly, there is a psychological difference between these situations; I suspect different brain structures take the lead role when odds are easy to calculable vs. when they are not.

But to make this minor point the fulcrum of entrepreneurship seems absurd. Aside from the Bayesian critique (uncertainty about probabilities just gets baked into the posterior), there is a strong argument that equivocality and ambiguity of the state space is more fundamental to entrepreneurial opportunity than an inabiltiy to form probabiltiy estimates. In fact, quite a bit of “uncertainty” aversion to me looks like a psychological cost of going to the trouble to structure one’s beliefs about something, not a difficulty in coming up with posterior distributions for those beliefs.

Sunday’s New York Times Magazine has an interesting article by Micheal Lewis in which he applies his Moneyball formula (follow innovative practitioners to explore the contours of a competitive arena and how it changes) to the developing market for catastrophe bonds. The essence of the Lewis article is that there is plenty of entrepreneurial opportunity in applying appropriate probabilistic risk calculations to things that have previously been treated in a cursory fashion. Knightians might not approve, but the point seems hard to refute.
2. Peter Klein | 29 August 2007 at 12:31 pm

Steve, I think you’re missing the point. To explain profit and the firm, the ontological status of uncertainty is not that important (you can interpret it in terms of subjective probability theory if you like). What matters is whether risks are insurable. As long as some risks are uninsurable — or, in Grossman-Hart-Moore terminology, as long as some variables are noncontractible — then there is a role for ownership and the firm. If not, a network of independent contractors will do fine.

BTW you might check out Zeckhauser’s “Investing in the Unknown and Unknowable.” Do you think he’s blowing smoke?